1. Cost-Benefit Analysis: Additional Considerations
Environmental Economics, Lecture 16

2. Outline Limitations of Cost-Benefit Analysis Discount rates
Option values
Appropriate use of cost-benefit analysis

3. Limitations of Cost-Benefit Analysis
Equity & distributional considerations
Focus on total costs & benefits, not marginal
Possible to manipulate cost-benefit analyses.
Sensitive to analysts assumptions on
Discount rate
Treatment of risk/uncertainty

4. Distorting a cost-benefit analysis
The “jobs game”
Example: the British Olympic Association argues that a “benefit” of London Olympics is job creation (9000 full time jobs).
What are the people who will take these jobs doing now?
Direct wage costs are a cost, not a benefit.
Reallocation of currently productive labor is also an opportunity cost, not a benefit.

5. Discount Rates
How should a cost-benefit analysis value future benefits.
Present value (example)
I offer you $105 next year
The risk-free interest rate is 5%.
$105 is just as good as getting $100 now and putting it in the bank.
Present value of $105 next year is $100.
See Tietenberg, pp

6. If present value, what is the right discount rate?
Market rate gives indication of our social willingness to tradeoff current and future benefits.
Can use comparisons between risk-free and risky assets to impute “market cost” for risk.
Traditional approach. Use long term rates on govt. bonds as “risk-free” measure and then adjust for risk.
The size of adjustment varies by analysis
Assumptions about interest rate can make a big difference (see example 3.5 and Barrett)

7. Considerations on discount rate
Should tradeoffs between present and future observed in private markets drive our public choices?
Private risks can be “hedged” or diversified.
Possibility of catastrophic changes
Public values vs. private values
If public sector uses a lower discount rate, then more projects with longer payoff periods pass cost-benefit analysis.

8. Evidence on discount rates for environmental goods
Observed behavior on energy efficiency (high implicit discount rates)
Some survey experimental evidence points to higher discount rates.

9. Option Value Value of Flexibility (See class notes)
Value of new information (Example from Jinhua Zhao, Iowa State)

10. Example: New information
Example: risk neutral planner. Will get further information about environmental benefits next year
Expected payout = $10/year
Expected NPV = (10/0.1)-84=$16
Go ahead: invest now

11. Example cont’d Consider waiting till next year to decide?
If unfavorable ($5), 5/.1 < 84 (Don’t invest!)
If favorable ($15), 15/.1-84= $66 (Invest)
Expected payoff = (.5)(66)/1.1=$30
Should not invest now! (30 > 16)
Delay helps avoid unfavorable investment that you will regret given the new information.

12. What is the story? Hysteresis: waiting has value when
There is uncertainty in payoff of investment
You can learn in the future by delaying
Investment is irreversible or costly reversible
The value is called option value
Much like financial option value
Example: call option: opportunity to invest in year two
Value is $30
Investment now kills this option
Invest now only if ENPV ¸ OV, or if the benefit can cover both the cost and the OV
Investment now competes not only with no-investment, but also with investment later.

13. Applications Global Warming Krutilla-Fisher (Pearce and Turner, ch 10)
Argument for research or learning by doing
Argument for waiting for new infromation.
Krutilla-Fisher (Pearce and Turner, ch 10)
Development decisions are irreversible. Should include value of new information.

14. Policy Recommendations from Economists
See Arrow et. al